The large number of ETFs has little to do with serving your best
interests. Below are three red flags you can use to avoid the worst ETFs:

1. Inadequate Liquidity

This issue is the easiest issue to avoid, and our advice is
simple. Avoid all ETFs with less than $100 million in assets. Low levels of
liquidity can lead to a discrepancy between the price of the ETF and the
underlying value of the securities it holds. Plus, low asset levels tend to
mean lower volume in the ETF and larger bid-ask spreads.

2. High Fees

ETFs should be cheap, but not all of them are. The first step here
is to know what is cheap and expensive.

To ensure you are paying at or below average fees, invest only in ETFs with total annual costs below 0.44%, which is the average total annual cost of the 447 U.S. equity Style ETFs we cover. The weighted average is lower at 0.15%, which highlights how investors tend to put their money in ETFs with low fees.

Figure 1 shows Forensic Accounting Long-Short ETF (FLAG) is the most expensive style ETF and State Street SPDR Portfolio Large Cap (SPLG) is the least expensive. Absolute Shares Trust (WBIA, WBIL) provides two of the most expensive ETFs while State Street (SPLG, SPTM) and Schwab (SCHX, SCHB) ETFs are among the cheapest.

Figure 1: 5 Most and Least Expensive Style ETFs

Sources: New Constructs, LLC and company filings

Investors need not pay high fees for quality holdings.[1] State Street SPDR Portfolio Large Cap ETF (SPLG) is the best ranked style ETF in Figure 1. SPLG’s Neutral Portfolio Management rating and 0.03% total annual cost earns it an Attractive rating.[2] iShares Morningstar Large Cap Value ETF (JKF) is the best ranked style ETF overall. JKF’s Neutral Portfolio Management rating and 0.28% total annual cost earns it a Very Attractive rating.

On the
other hand, Vanguard Mid Cap Growth Index Fund (VOT) holds poor stocks and
earns our Unattractive rating, yet has low total annual costs of 0.08%. No
matter how cheap an ETF, if it holds bad stocks, its performance will be bad.
The quality of an ETFs holdings matters more than its price.

3. Poor Holdings

Avoiding poor holdings is by far the hardest part of avoid bad ETFs, but it is also the most important because an ETFs performance is determined more by its holdings than its costs. Figure 2 shows the ETFs within each style with the worst holdings or portfolio management ratings.

Figure 2: Style ETFs with the Worst Holdings

Sources: New Constructs, LLC and company filings

Invesco appears more often than any other provider in Figure 2, which means that they offer the most ETFs with the worst holdings.

First Trust U.S. Equity Opportunities ETF (FPX) is the worst rated ETF in Figure 2. Alpha Architect U.S Quantitative Momentum ETF (QMOM) also earns a Very Unattractivepredictive overall rating, which means not only does it hold poor stocks, it charges high total annual costs.

Buying an ETF without analyzing its holdings is like buying a stock without analyzing its business and finances. Put another way, research on ETF holdings is necessary due diligence because an ETF’s performance is only as good as its holdings’ performance. Don’t just take our word for it,see what Barron’s says on this matter.